August 23, 2010 marks the seventieth anniversary of the signing into law of the Investment Company Act of 1940, the law that governs mutual funds and other investment companies.
The Act was designed to address abuses that characterized many investment companies in the 1920s, such as excessive leverage, self-dealing by fund managers, and inadequate disclosure, while permitting funds to innovate in the interest of investors.
The Act has been a great success. Mutual funds, while not problem-free, have generally avoided abuse. The industry has introduced a myriad of new products and services, and has grown from less than $500 million in assets in 1940 to over $10 trillion and almost 90 million shareholders today. A major reason for this success is that the industry and its regulator, the Securities and Exchange Commission, have resisted calls to weaken key protections set forth in the Act.
The major regulatory problems the industry and investors face today are not due to the original 1940 Act, but to amendments that were added in subsequent years. These problems fall into two categories: Attempts at rate regulation and inappropriate exemptions for new types of investment companies.
Attempts at Rate Regulation
The drafters of the Investment Company Act intentionally steered away from rate regulation. Thus the Act did not address levels of management fees paid by funds or levels of sales loads paid by investors.
However, in the late 1960s the SEC embarked on a campaign to have the Act amended to impose rate regulation on both management fees and sales loads. The result was the 1970 amendments to the Act. New Section 36(b) imposed a fiduciary duty on fund advisers with respect to compensation paid by the fund and provided that an action for breach of this duty could be brought by any shareholder. New Section 22(b) authorized the NASD (now FINRA) to adopt rules governing sales loads. In 1975, the NASD adopted a rule imposing limits on front-end sales loads, expanded in 1992 to encompass deferred loads and 12b-1 fees.
Both attempts at rate regulation have resulted in continuous problems for the fund industry and investors. Management fees have been the subject of constant litigation, which, despite the Supreme Courts recent decision in Harris, is likely to continue. Fund directors focus on fees may have reduced their time and energy available to perform their key duty identifying and addressing conflicts of interest. Forty years after the 1970 amendments, the SEC and FINRA are still wrestling with rate regulation of sales loads, with the SEC recently issuing a 270 page release. Total costs borne by fund shareholders have declined precipitously in recent years, but this appears to be due to the replacement of front-end loads with 12b-1 fees and shareholder movement to lower cost funds, rather than the 1970 amendments.
The best solution would be along the lines recommended by the SEC staff in 1992 amend the Act to permit a fund adviser to charge a single fee that could be used for any purpose portfolio management, shareholder service, payments to brokers, etc., and do not subject the fee to directorial or judicial review. While this simple free-market approach would end the problems inherent in rate regulation, I would not bet on its adoption any time soon.
Inappropriate Exemptions for New Types of Investment Companies
The drafters of the Act did not limit its reach to the types of investment companies in existence in 1940, but instead broadly defined an investment company as any issuer which is engaged in the business of investing in securities. The realized that this broad definition might inadvertently sweep in some entities and therefore provided exemptions for banks, insurance companies, broker-dealers, and charities. These exemptions for accidental investment companies generally have not created problems for investors.
But over the years exemptions have been added for new types of classic investment companies:
-- In 1970, an exemption was added for bank collective funds and insurance company separate accounts sold to retirement plans and individuals in those plans.
-- In 1992, the SEC adopted a rule exempting asset-backed pools that receive high ratings from credit rating agencies and meet other conditions.
-- In 1996, an exemption was added for funds sold exclusively to individuals with $5 million in investments and institutions with $25 million.
These exemptions have created serious problems for investors in these investment companies, who are denied basic protections such as limits on leverage, prohibitions against self-dealing, and full disclosure. Moreover, the 1992 exemption for asset-backed pools and the 1996 exemption for hedge funds contributed to over-speculation and the resulting 2008 financial crisis. All three exemptions should be repealed.
Finally, the problems encountered by investors in these unregulated investment companies highlight the protections that the Investment Company Act provides to mutual fund shareholders. Lets take a moment to mark the seventieth birthday of this very successful law.
Matt Fink was with the Investment Company Institute from 1971 to 2004 and served as its president from 1991 to 2004. He is the author of a history of mutual funds, The Rise of Mutual Funds: An Insiders View, published by Oxford University Press and set to be revised next year. He can be reached at firstname.lastname@example.org.